In fact, investors in debt would tend to look at the real return on such investment as well as the perception on the exchange rate before taking any decision on where to invest. This means that inflation matters, not just present inflation, but also expectations of the same. When critics highlight our obsession with inflation and exchange rates, they probably err as these are genuine considerations for any central bank. Also, while industry would like interest rates to come down to bring about growth (though anecdotal experience does not justify the same), a central bank, which takes a more macro look, has to look at all these factors when taking a call on policy options.
Looking at various markets in the world, an interesting commonality is that nominal bond yields have actually moved up over the last year by varying degrees in different countries. The yield on 10-year GSec or its equivalent has increased by more than 100 bps in countries like Brazil (281), Indonesia (230), South Africa (137), UK (118), USA (114) and Sweden (102). It has been over 60 bps for Mexico, Thailand, Korea, China, Switzerland, and Germany. In case of India it has been almost flat at the current rate of 8.27%. Quite clearly, we will have to compete with markets where yields are increasingboth developed countries as well as competing emerging markets.
On the positive side, as the accompanying table shows, at the present level of real yield (which is what matters to investors) where the nominal rate is adjusted for the inflation number, our real rate is at 2.48%. It is at the upper end of the ladderthird in the list of 18 selected countries, with Latin American countries such as Brazil and Mexico ahead of us. Inflation has been high in countries like Brazil, India, Mexico, Russia, South Africa and Indonesia. Again, due to structural reasons, inflation tends to be higher in emerging markets than in developed countries where price increase is more controlled. Investors will, necessarily, take a call on future inflation and hence, inflationary expectations play a role.
It is here that the monetary policy approach is important as it provides a signal to the potential investors indicating the will of central banks in controlling inflation. Any laxity in policy approach in the midst of high inflation will cause apprehension in the minds of investors. RBI is cognisant of this factor and hence, talks very often of real interest rates as a driving factor behind monetary policy. In a globalised world, where foreign investment is providing succour to the CAD, real interest rates become even more important as investors do not suffer from money illusion.
The accompanying table also provides information on exchange rate movements across countries vis vis the dollar over the last year. Currency depreciation is another factor looked at by investors when investing in any market. Irrespective of whether the funds are flowing into equity or debt, the final purpose is to remit gains back home where the exchange rate plays an important part in their strategy. As seen in the table, the real return is one way of choosing across markets when it comes to debt. But the exchange rate is a clinching factor because an inherently volatile or weak currency will lower effective return for foreign investors when money is to be repatriated. Again two factors matterthe nominal and the expected depreciation.
Based on nominal depreciation, the rupee has been more adversely affected and is third in the list with Japan and South Africa being above us. Intuitively, it can be observed that when the currency falls by 16% in a year, the returns on both debt and equity are actually wiped out in real terms even if inflation is under control. Therefore, having a stable currency is a pre-requisite to getting foreign investment. As a corollary, central banks also need to provide a signal that they are serious about protecting their respective currencies and hence would have to have policies in place that stabilise their currencies. A normal depreciation which will vary across countries following trends will be acceptable, but volatile currencies would be a deterrent.
Given the overall state of uncertainty relating to the Fed action in the coming months and the wide array of choices that foreign investors have, RBI and government have to take a call on how they would like to prioritise the goals for our economy. As long as the CAD is high, foreign funds are a necessity, especially through the investment route, as they help to stabilise the balance of payments and hence, the rupee. In these circumstances, we do need to see what other countries are doing and the opportunities being offered through returnsnominal and realwhich is backed by currency policies.
Based on the approach to interest rate policy, the revealed preference of RBI appears to be firm and consistent towards maintaining a stable regime of exchange rates while ensuring a positive real return on debt to retain India as an option for potential investors. This will be painful to industry as it prolongs the recovery process but appears to be inescapable under these testing circumstances. RBIs actions on interest rates, inflation and exchange rates have definitely been pro-investor even though the policies may not have always delivered according to script.
The author is chief economist, CARE Ratings